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Wednesday August 11, 2010 - 15:40:06 GMT
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Fed Pricked Risk Bubble (FXA)

Fed Pricked Risk Bubble


When the Fed takes a step closer to printing more money as it did on Tuesday and the dollar has its biggest one-day rise in over a year against the euro (and is weaker versus the yen), something else is going on that trumps basic economic reason.


In one paragraph the Fed changed the market narrative on Tuesday.  Out the window went the narrative of pricing assets, commodities and FX on fundamentals (relative ones for FX), and in the window flew a new (old) narrative…risk aversion.  It is déjà vu all over again…it looks and feels like 2008…well, in miniature. 


Despite the at best mixed track record the Fed has in forecasting economic activity, inflation and unemployment, the markets hit the default button Tuesday and ran to the LCD…Fed knows more than the rest of us on anything economic.  If the Fed is worried about deflation, we should be worried about deflation.  Risk assets do not perform well in deflation period…have a look at the Nikkei for the last 20 years.


Ironically, part of the intent of the Fed is to use monetary policy (QE) to support asset prices and risk taking…this is key to breaking (or in this case preventing) the psychology of deflation.  Indeed the success of the first round of QE from the Fed in 2009 was to incentivize investors to hold riskier assets like bank stocks, corporate bonds and anything with yield.  Rising asset prices yields a positive wealth effect, a sea change in psychology.  But what we are learning some 2 years after the crisis is that consumers no longer believe in the stock market and face insurmountable wealth losses from their main asset…the home…which overpowers any feel-good effect the Fed might achieve with QE and near infinite zero-cost funds to the banking system.  Deleveraging need trumped the policy response.


Tuesday was a day when investors on balance awoke from a drug induced coma, looked around and decided the world still looks very risky and return of capital rather than return on capital is key.  Surely the Fed must have considered this risk ahead of time…it is the worst outcome to the news of a policy change the Fed could have hoped for. 


Maybe the Fed should blame itself in part for failing to communicate (Cool Hand Luke) ahead of the announcement.  Indeed the price action Tuesday ahead of the news was abysmal…Larry Meyer crazy call epitomized the failed communication. 


And this narrative shift is playing out globally.  European (Club Med plus Ireland) bond spreads are widening versus bunds and rather dramatically.  The 5-yr CDS on same EZ miscreants is also present.  ECB lent 2 EZ banks USD today at 1.18% (well north of USD LIBOR…they could not borrow in interbank market). 


I think what officials don’t get is how vulnerable the global financial system is – a tug on the system can yield unexpected and profound results and mostly negative ones.  Banks remain undercapitalized, with insufficient marks, large off balance sheet or hold to maturity assets, mixed results on loan performance – see Bank of Ireland today - and highly leveraged (Europe more than US).  And while not my bailiwick some make a very strong case that the plumbing of the banking system is still deeply compromised (insufficient collateral relative to claims and even more insufficient quality collateral). 


In other words there is disproportionate downside risk in asset prices from policy miscues of which Tuesday is a prime example.


Lastly, I would like to think we are witnessing a transition in the Great Recession…not unlike the Great Depression.  The collapse in asset prices and confidence in the banking and financial systems followed by lengthy weak real economic activity.  And sadly the ability of monetary and fiscal policy short of the Colin Powell overwhelming force approach (see Mike Casey at DJN column on this) to impact the real economy in the short- and medium-run is very limited…so limited that there is a vibrant if inane debate raging over whether the policy response to date has had any impact. 


How about Bernanke hold a press conference – on the record – and let us all know what the Chairman is thinking (with all do respect Bullard’s views are superfluous)?  I am not holding my breath on this one, but the USS Titanic is running straight at another iceberg (maybe not ruin and collapse, but lengthy stagnation and deficit/debt trap…nearly equally intolerable) called the real economy having hit the financial iceberg in the fall of 2008.  For the Fed, WH and Congress (and every other monetary authority on the planet – including the European monetary and fiscal free riders) it is all hands on deck.


For those less inclined to watch this unfold in the inner recesses of the financial system (repo, CP, bank funding, CDS), take the front row seats in equities, risk free bonds and FX…tighten the seat belts and assume the crash position.


David Gilmore  




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